Corporations are continually faced with capital allocation decisions. Investors, however, rarely have the information to know if management is making the right moves, since public financial statements don’t shed light on internal rates of return. But, when management returns cash to shareholders, investors can better assess the chosen approach. Companies tend to return excess cash as dividends or share buybacks.

Dividends and buybacks

As far as dividends go, extra cash can be returned to investors as an increase to the regular payout, or as a special, one-time distribution. The market prefers increases to regular dividends for good reason—they offer more stability and transparency, and promise ongoing discipline.

Dividends offer greater flexibility, since investors can decide where to spend the cash (essential for clients who rely on income generation). The downside of getting cash now is that dividends can trigger a taxable obligation, whereas buybacks allow for potential tax deferral.

The biggest risk is when investors get hooked on the income, and reach for higher yields that aren’t sustainable based on the underlying cash flows of the business. Advisors also need to be wary of overpaying for names that seem to offer sustained dividend growth (see AER December 2014).

Meanwhile, in the U.S. and Canada, buybacks have exploded in recent years. The biggest impact has come from the technology, healthcare and consumer discretionary sectors. S&P 500 companies repurchased shares worth $553 billion in 2014, up from $400 billion in 2012, and $300 billion in 2010.

Much of the growth in buybacks is a result of low interest rates. Many companies have issued ultra low-cost bonds simply to repurchase shares. But, it’s important to draw a distinction between companies optimizing an underleveraged capital structure (i.e., Apple) versus those pushing leverage as high as possible. When a company stretches its balance sheet to the point of affecting its credit rating, advisors have to question whether management is artificially boosting EPS. With CEO tenures shrinking, there’s a drive to focus less on the longer term, and more on immediate results. When natural growth slows, executives have little time to make an impact. The market also appreciates a myopic approach when it results in higher share prices, and the easiest way to get that is to cancel shares and show better EPS, even with flat earnings.

In the last few years, all the pieces have fallen into place. Similar to the way investors enjoy the flexibility of dividends, management loves the greater flexibility of buybacks. Buybacks have the ability to affect share prices and EPS, separate from the fundamental performance of the company.

So it’s tough to watch companies launching buybacks just because management thinks the share price is undervalued. It’s reactionary and ill-planned from a strategic perspective.

The market is adept at working out inefficiencies in value. Investors don’t need a management team swaying the market based on what they think is a flagging share price. For instance, Marathon Oil spent $1 billion repurchasing stock in the first half of 2014 and then suddenly stopped, even though management was authorized to buy more. The company’s decision to time the market meant shareholders missed the opportunity to capitalize on the decline in share price, which fell to 30% below the average buyback amount. So, it’s better to see companies returning cash through buybacks as a recurring practice. It works for investors and companies, and is akin to dollar-cost averaging.

If an investor comes into a windfall, advisors will counsel him to wade into the market slowly, so he doesn’t miss lower prices later. Management should do the same when investing the money shareholders put in their company. In turn, advisors must avoid companies with management teams that are intent on timing the market with share repurchases, or too focused on boosting EPS.

Best of both worlds?

Focusing on companies that extend their buybacks over multiple years is borrowing a page from dividend investors, who are attracted to spreading out cash on a regular basis. This approach is stable, disciplined, transparent and tax-advantaged. It takes some of the flexibility out of the hands of management, which is a good thing from a behavioural investing perspective.

But, monitor how repurchases are cancelling out shares that have been issued to management as part of their overall compensation. Keeping the share dilution under control is good, but over time, it masks how much of the company is being transferred from investors into the hands of insiders. The accounting impact of this maneuver also should not be lost on investors because it can artificially inflate free cash flows over the long term. Some companies prefer to use both buybacks and dividend increases to spread extra cash around, because the cash outlay for the buyback is partially offset by the reduced dividend payout from the lower number of shares.

The dual approach can also offer investors the same opportunity that some executives receive. Enrolling in a direct investment plan allows investors to take extra shares, instead of cash, as dividends. The dilution of shares can then be offset over the longer term by regular buybacks, which provide investors who are enrolled in the DRIP with a higher relative equity interest, and greater exposure to company earnings.